In today’s low-rate environment, subordinated debt offers an attractive yield, less sensitivity to changes in interest rates than other bonds and less volatile returns than equities.
Historically, banks had been required to hold sufficient capital to absorb unexpected losses that might arise from another shock or combination of events – such as a severe global recession, a sharp fall in house prices or negative interest rates as well as fines and other costs associated with misconduct. Today’s tighter regulatory framework means that banks must hold even more capital to act as a buffer against substantial future losses.
In response, Europe’s banks have issued more subordinated debt – about €214bn since regulations started taking effect – as a way of generating this extra capital. Like most fixed income securities, these bonds pay a regular coupon, but there are strings attached. That’s because the regulators have focused on shifting the financial burden of any potential problems away from taxpayers and onto investors.
As the name suggests, subordinated debt is repayable after other debts have been paid, which does make it more risky. In particular , if a bank comes under stress and its core capital falls below a certain threshold then holders of the subordinated bonds can find their stake converted to equity or even written down to zero. The regulators also have the discretion to halt the coupon payments in certain circumstances.
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Regardless of underlying conditions, banks will continue to issue regulatory capital in the form of subordinated debt to meet their requirements, creating an ongoing opportunity.